Fixed Income Focus: Ireland & Portugal

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1 In the past decade we have seen droves of investors driven to global fixed income markets in search of higher yields. While the global pool of fixed income securities more than doubled, we saw asset bubbles burst and publicly funded bailouts amass around the globe. As the sovereign debt crisis in Europe continues to unfold, we could see unique high yield opportunities in a market typically viewed as a safehaven for investors: The Government Bond Market. The Euro Zone: As the sovereign debt crisis intensified in 2010 the world watched as Greece, Ireland and Portugal emerged as the leading candidates for default. With Greece s systematic default all but carved in stone, Ireland and Portugal s financial uncertainty continues to drive bond prices down and creates an interesting market for the yield-chasing investor with a strong stomach. Assessing Portugal and Irelands default probability is one thing, but noting how these nations bonds have performed throughout history may furnish a unique and valuable perspective on the overall debt picture. Figure 1 Since adopting the Euro in 1999, the Portuguese and Irish 10-year bonds have moved in almost singsong unison for 9 years. Until 2008, the spread between the countries on-the-run 10-year notes had never exceeded 36.3 basis points (see Figure 1) while the bonds fluctuated between 3%-6% yields (see Figure 2). These closely correlated yields are not unique to Portugal and Ireland and are demonstrative of a general credit and liquidity risk assessment of the EU countries as a Figure 2 whole. However, one may

2 argue that the advent of the global economic crisis beginning in 2008 has pushed the European Fixed Income market back to a period of historical normality, where government bond risk is once again placed on the individual issuing country and not the European Union altogether. The historical government bond picture for Ireland, Portugal, and the rest of Europe might be more telling of future trends than a study of movements over the past decade. As pressure mounts to dissolve the Euro Zone and abandon the Euro, one would assert that yield variance on a particular European country s debt has less of an effect on similar bonds issued by its neighbors. Throw in a growing mistrust over the presiding rating agencies that asses the credit worthiness of the Euro Zone countries and any investment decisions become that much more meticulous. Ireland as a Leading Indicator: If we study the yields on the 10-year bonds for these two countries over a long term, we can see some unique trends. For almost every rally and selloff the Portuguese 10-year bond has seen over the past century, it has been preceded by a similar event on its Irish counterpart. In the 1970 s, the global economy faced the worst economic uncertainty since the Great Depression. The two-year bear market of had greatly affected financial markets around the world and was compounded by the 1973 oil crisis and the devaluation of the US Dollar. Amidst the Carnation Revolution in Portugal, the economy could not sustain the ~56% per capita GDP it had relished throughout the 1960 s and a sell-off on its debt began in 1973 that would last until The only consolation to this sharp drop in price was a brief respite where Portuguese bonds rallied in Albeit a global recession throughout the 1970 s, fixed income markets responded much faster to the Irish bonds with their sell-off peaking in 1974 and yields remaining relatively stable through While Figure 3

3 a deeper understanding of fiscal policy in the region and other pressures may explain the lag between these particular Portuguese and Irish peaks & valleys, the correlation is visually apparent (see Figure 3). Looking further ahead, we can see the Irish bond exhibiting yield spikes well before the Portuguese 10- year on several occasions; hitting historical yields of 19.16% in 1982, 22 months prior to the Portuguese 10 year reaching its peak yield at 22.80% in October of Figure 4 So What Now? If the last 12 months gives us any indication of the debt situation in Europe then one thing is certain it s every country for itself. A blanket assessment of credit worthiness in the Euro Zone as is a thing of the past. Even as the total debt outstanding for Ireland and Portugal as a % of GDP continues to move increasingly in tandem (figure 5), we will continue to see spreads move wider and wider amongst their government bonds. Until a remedy can be provided that addresses the growing liquidity and solvency concerns in the region, investors will be forced to look elsewhere for safety while others are drawn to it for its attractive yields. A ten year study or even twenty year history of government debt in the Euro Zone was sufficient as Government debt in the region seemed to correlate closely, as did fiscal policy. With the future uncertain for the Euro remaining intact and Euro Zone nations ready to point fingers at the economic maladies confronting its European brethren, limited data on the region will no longer serve the financial community. Using the data provided by GFD, one has the tools to monitor the historic epochs that mirror or closely resemble the present day crises. Data from the 1970 s, the Great Depression and other trying times in Global Economics can shed light on the situation at hand.

4 As the debt crisis continues to unfold, we can see that the creation of the euro did not ensure the notion that sovereign risk is similar across multiple countries. This fundamental truth means that we must now look beyond the last ten years of historical data and pursue correlations well into previous historical periods. We would like to think that we are smarter than our predecessors, but as many GFD clients are beginning to recognize, history can and will repeat itself if we are not careful. Figure 5 GFD File ID (Symbol) Current Series IGIRL10D IGPRT10D CGTIRLA CGTPRTA File Description (Name) Periodicity (dates) Monthly From May 1928 To May 1986, Ireland 10-year Government Bond Yield Daily From May 1985 to Dec 2011 Monthly From Nov 1823 To Sep 1988, Portugal 10-year Government Bond Yield Daily From Sep 1988 to Dec 2011 Ireland Central Government Total Debt (% of GDP) Annual from Dec 1998 to Dec 2009 Portugal Central Government Total Debt (% of GDP) Annual from Dec 1997 to Dec 2009

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